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Michael Pascoe: Interest rates won’t work like they used to

When a supply shock increases inflation too much, lifting interest rates can just make it worse, writes Michael Pascoe.

When a supply shock increases inflation too much, lifting interest rates can just make it worse, writes Michael Pascoe. Photo: TND

The Reserve Bank – and those of us who watch the bank for a living – tend to enjoy a good graph. Governor Philip Lowe flashed a couple of rippers on Tuesday night.

They were illustrations along the way to a bigger story about how inflation is going to be a wilder ride in the years ahead, with the implication that raising and cutting interest rates won’t be much of a tool for taming it.

That’s a big statement by the RBA, one that should make thinking governments think. I’ll come back to it.

But first the graphs.

Whack this one under the nose of the nearest climate-change sceptic or politician pretending the world is doing enough to avoid catastrophe. As Dr Lowe observed: “Over the past 20 years, the number of major floods has doubled and the frequency of extreme heatwaves and droughts has also increased significantly”.

As for the scale of change over the past 80 years, well, the graph speaks for itself.

Dr Lowe fingered climate change as one of four factors that are playing merry hell (I’m translating from RBA-speak) with the supply side of the economy.

As the governor explained, in the good ol’ bad ol’ days, central bankers believed inflation being too high or too low was a matter of demand being too strong or too weak, so all they had to do was increase interest rates to weaken demand or cut them to encourage demand and then roll on to lunch and a few bottles of very fine red.

Problems with supply are pushing inflation around.

But now problems with supply, not demand, are pushing inflation around and the old blunt instrument of monetary policy doesn’t work very well.

In RBA-speak:

“Life is more complicated in a world of supply shocks; an adverse supply shock increases inflation and reduces output and employment. Higher inflation calls for higher interest rates but lower output, and fewer jobs call for lower interest rates. It is likely that we will have to deal with this tension more frequently in the future.”

Translation: When a supply shock increases inflation too much, lifting interest rates can just make it worse.

Which is something the RBA board should be thinking very, very seriously about before lifting interest rates again on Tuesday week.

The case for keeping the status quo

Dr Lowe effectively made a case for leaving rates where they are or at least not going very much further.

However, having been stung so badly about the conception of “no rate rises until 2024”, he was at pains in the same speech to make clear the RBA was about one thing and one thing only: having inflation averaging somewhere in the 2-to-3 per cent band “over time”.

He was still promising – or at least threatening – more rate rises. That’s despite making a case for such further rate rises being bad for the economy and not doing much to tame inflation. Go figure.

But back at the more interesting stuff. Another of the four reasons the governor gave for the supply side bedevilling central bankers was the global transition to sustainable energy.

(Yes, it is happening. No, it’s not happening fast enough.)

What is a worry for the RBA is the disruption in the period while renewables are taking over the fossil fuels are becoming fossils.

In Lowe-speak:

“There is very significant investment in renewable energy around the world as we transition to green energy. But, at the same time, the existing capital stock that is used to produce energy is depreciating quickly, through decommissioning or lower levels of sustaining investment.

“It is difficult to make predictions here, but it’s probable that the global capital stock that is used to produce energy will come under recurring pressure in the years ahead. If so, we could expect higher and more volatile energy prices during the transition to a more renewables-based energy supply.”

Translation: Investors are deserting what they know will become stranded assets and they’re not doing it in a co-ordinated fashion with investors going hard into sustainable energy, so there will be spikes and problems with energy prices in the years ahead.

Follow the money

But Dr Lowe’s interesting insight as a sidebar to that was to follow the local resources industry money.

The second Law of Journalism is “Follow the money”. (The first should be “Cui bono – who benefits?”)

For all that the resources industry lobbies to preserve its carbon pollution as long as possible and pocket politicians along the way, it is not putting its money where its mouth is, aside from what it takes to buy pollies.

Normally when commodity prices boom, capitalists invest in producing more of those commodities to get rich on the high prices. (That the extra investment ends up lowering prices is a story we won’t bother with today.)

What the following graph shows is that, unlike the last resources boom, investment isn’t following the higher prices.

There is an exception that proves the rule – lithium ore miners are going gang busters – but Big Carbon knows the party isn’t going to last.

In Lowe-speak:

“In the earlier boom, higher commodity prices led to a surge in investment in the resources sector. This substantially added to Australia’s capital stock and thus our ability to supply resources to the market.

“In contrast, the investment response this time has been negligible and there are few signs that firms are planning to increase supply in response to the higher prices.”

climate

Big Carbon knows the party isn’t going to last.

The RBA understands the climate-change crisis, but purely from an inflation point of view, Dr Lowe worries that supply not responding to higher prices means that we will end up with supply constraints – meaning prices jumping around.

(That lack of investment while prices are booming also explains why mining sector profits are through the roof, into the clouds and on the way to the moon.)

Stumbling blocs

The other two supply side issues concerning the RBA are the winding back of globalisation and demographics.

International trade is no longer growing faster than the global economy.

“Trading blocs are emerging and there is a step back from closer integration,” Dr Lowe said – which is more politic than saying the United States is determined to bifurcate the world as it fights to maintain first place as an economic power.

“Unfortunately, today barriers to trade and investment are more likely to be increased than removed. This will inevitably affect both growth in living standards and the pricing of goods and services in global markets.”

On the demographic front, the world enjoyed a great leap forward (no irony intended) by absorbing the workforces of China and Eastern Europe, women increasing their participation in the labour market and the working-age population rising in both advanced countries and China and Eastern Europe.

Now, the absorption is in the past, women’s participation rate isn’t rising as much and the working age population in the aforementioned countries is turning down while the dependency ratio rises.

So the supply side will be more of a problem for a number of reasons.

So the old central bankers’ blunt instrument won’t work as well.

So why is the RBA promising to keep bashing us with it?

Because, Dr Lowe said, the board’s priority is to return inflation to its target over time.

“It is resolute in its determination to make sure that this current period of high inflation is only temporary.”

Given the rest of his speech, that’s a bit like saying we’re determined the operation will be a success whether or not the patient dies.

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